I mentioned in my last article that one of my favorite bloggers – Nate at Oddball Stocks – wrote a post “Why Small Caps?” It’s a good post and you should read it. I want to take the conversation in a slightly different direction. Why focus on microcaps? Why not dabble a bit in big caps and small caps? Why focus at all?

William Goldman – a screenwriter – tells a story about his time writing All the Presidents Men. He would go to the producer on that movie and ask him what he thought of a scene the way it was written. Should it be more edgy or less edgy? Should it be faster paced or slower? Which way should he rewrite it?

Both ways. The producer always said: “Both ways.”

That’s not all he said. He repeated a phrase that Goldman learned to hate: “Don’t deprive me of any riches.” This became a mantra: “Don’t deprive me of any riches.”

Nobody likes to focus. When I’m standing here – I’d say sitting to sound more normal, but I’ll make a confession here, I type standing up – I could be talking about a lot of different things. I’d like to be talking about a lot of different things. I will try – I usually fail – to talk about one subject. I usually manage to at least talk around that same subject.

When you sit down (or stand up) to write something – it’s all potential. There is no focus. And that can feel very good. For one thing, there are no mistakes. Only opportunities. As you actually start to write – you make choices. That’s almost all you do. And – as you do that – the ideal in your head gets worse and worse. The end product might be good. That movie went on to win an Oscar. But whatever it has as a finished product, there’s one thing it will always lack – potential.

An idea has potential. A process might have some left in it. A product can’t have potential.

Investing starts with an idea. Sometimes it starts with such a twinkle of an idea – a distant little rumbling that isn’t really connected to anything yet, more like a twitch of opportunity – that you barely know what started you down a path. But I promise you – it’s an idea. It’s something that got you headed in a certain direction. Like a wolf might wake up and sniff the air and then head off in that direction hoping to eat – so the investor tracks his prey.

This is where focus first starts. Before you’ve scented anything – there’s no focus at all. I know the feeling. I have thought about stocks in many countries, I’ve thought about securities of many types (convertible preferred stocks, options, etc.), I’ve thought about special situations – I’ve thought about a lot of things.

There is no focus in that. Just a whiff of opportunity.

I got a whiff of opportunity in three related cases:

· Barnes & Noble (BKS) – later sold

· Dell (DELL) – never bought

· Ark Restaurants (ARKR) – still own

In each case, there was someone interested in buying the company, offering to buy the company, fighting for control – whatever. That was the whiff of opportunity.

I have smelled it many times in such situations – and I don’t specialize in these. I did well in a company called Bancinsurance when its controlling shareholder – think the Michael Dell situation with a company about 500 times smaller – offered to buy the stock at what seemed a low price.

At this stage, you are very excited because everything is potential and nothing is actual. You don’t know all the problems that will pop up – all the warts that will drive you away. You just smell opportunity.

Then you move into your process. This is different for everyone. And this is where specialization helps. This is where focus matters – it matters in your process.

Process is habit. It is tacit knowledge. The kind of stuff you learn from mentors and victories and defeats. It is not what you learn from textbooks. It is not theory. It is everything else. It’s stuff like “where to begin?”

Process is the first place where you start choosing. And, for this reason, it is very daunting and very limiting. It is daunting because many people don’t know where to begin. This is not unique to investing. Most people don’t know where to begin a screenplay – that’s why a producer paid someone else to write it – and I never know how I’m going to begin an article till I do. It always seems very daunting until you start typing.

It would be hard for me to set down rules on how to start an article, or start researching a stock, or start doing anything else I do frequently. It’s not something I think about. It’s possible – by stepping outside yourself – to monitor what you do. And then you can break down the steps.

I’ve tried to do this from time to time when I think about how I research a stock. I’ve noticed a few things. And – as I’ve noticed them – they’ve become more explicit in my mind.

Like everybody, I tend to stereotype stocks. This is a problem. It can be very, very helpful. It’s an incredibly powerful tool. The ultimate shortcut. I’ve mentioned metaphors before. The idea of using a stock you know as an analog for one aspect of a stock you don’t. You think about different points of the stock you don’t know and try to glimpse them through common points shared with other stocks. Sometimes, you know three or four stocks that – while different in most aspects – share one aspect with the stock you’re looking at. From there, you can think about how these aspects interrelate.

The quickest way to do this is immediately peg your new stock as just another example of an old stock. I look at Royal Caribbean (RCL) and go, “Oh, that’s just another Carnival (CCL).”As we stretch this further – “oh, that’s just another net-net. That’s just another dot com,” etc., we see the danger of these stereotypes.

I remember Nate at Oddball Stocks writing in some post – I don’t remember which – that there are some folks who say “I only want to buy high quality net-nets” and that doesn’t make sense because net-nets have something wrong with them. The first part of that argument – that it makes no sense to try to subsist on a diet of high quality net-nets alone – makes perfect sense. You can’t. It would be like trying to eat only the blossom of some flower that bloomed once a year.

But the second part – that there are no high quality net-nets – is so close to being true that it becomes a very dangerous idea. Obviously dumb ideas are not dangerous. Stereotypes that are mostly true are the most dangerous. In times of great stress – you can see this in backtests – a couple high-quality stocks do pop up on net-net screens. This can also be shown by looking backwards at the performance of either stock price or compounding book value (and ROE) of some microcaps. There are a few stocks that show they’ve compounded their share price at about 10% a year over the last 15 or 20 years.

That’s a high quality company. Especially because that record is better than American stocks generally. It’s also worth mentioning that if you are looking at something like net-nets – which presumably have low prices at their end point, today – their compound rates of returns should be severely hurt by this fact. A stock trading at twice the price-to-book, price-to-earnings, etc. will show a much better record simply because it has a much higher end point on the day you choose to screen.

The vast majority of net-nets – I don’t know if it’s 90% or 95% or 99.7%, but it’s not 65% – are low quality. This makes the stereotype mostly true. And therefore very dangerous.

The less you focus on an area of expertise, the more you have to operate by stereotypes. I know we would all like to think of ourselves as very open minded, not given to any biases, first impressions don’t mean a thing to us, we never generalize – but we do.

If you think correct thoughts about the full spectrum of what people from a certain country or religion or profession are like – it’s usually because you know at least two of them. You have firsthand experience. And you have firsthand experience with more than one person from that group.

I use people as an example here – because that’s the big taboo. You are going to try – you might fail, but you know you’re expected to try – not to stereotype people. It’s a moral issue. It’s part of your code of conduct. And your sense of being a good person.

You probably don’t feel that way about stocks. You probably don’t feel you are being terribly biased and lazy and a bad person by assuming a net-net is a piece of garbage unworthy of your time and attention.

Investing has another similarity to writing. Readers always ask writers about ideas. Writers never worry about ideas. They know that they always have many, many more good ideas – more stuff with potential – than will ever be realized. Ideas are cheap. It’s the difficulty in making all the little choices in deciding which idea to start with and how to shape it at each turn that’s difficult.

Ideas in investing are at least as cheap. There are literally thousands of stocks to choose from in the U.S. I recently ran a backtest – going back 15 years, to make this one tough – to see how many stocks would give what I thought was an acceptable (in both relative and absolute CAGR terms) return for a buy and hold investor over that time period.

This means, starting in 1998, how many stocks would have undeniably served you well if you simply bought them then and held them till today.

The list was impossibly long. But there were over 700 stocks on the list that anyone would have been very, very happy owning. They had very little in common in terms of what industries they were in. They did have some things in common – they were smaller than the stocks most investors buy, they improved their operations over that time period (became more competitive), and they often had a societal tailwind rather than a headwind.

Maybe you could have predicted some of them. Maybe you couldn’t have. My point is that – there were a lot of them. Apple (AAPL) was on the list. It wasn’t on the top. It was mostly unique for being big.

And that’s just American stocks. It’s important to remember that the period from 1998 through this point in 2013 hasn’t been a great one for American stocks. I didn’t just screen for relative outperformance – obviously a lot more stocks achieved that. I screened for the combination of a high enough rate of compounding (better than the stock market had achieved over its entire recorded history) and relative performance (better than a benchmark performed over the same time period). Hundreds of stocks passed the test.

Opportunity is not the problem. Choice is the problem. There are enough ideas – enough potential – out there for you to get very rich. You’re unlikely to get very rich investing in stocks. But it’s not because of a lack of opportunity. It’s because of bad choices.

So don’t be afraid to focus on a niche. Don’t be afraid to “deny yourself riches” by drawing your circle of competence a little more narrowly.

The good thing about a narrow focus is that you can get more from the same process. You can hone your process – work to improve the way you work – and in so doing get better results.

The more scattershot your approach, the harder it is to tie the lessons you’ve learned together into a single, workable – and personal – process.

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